Annaly Capital Managment Inc.'s Third Quarter Earnings: What You Need to Know

On Wednesday, Annaly Capital Management reported a 7% decline in book value per share, from $12.87 in 2014'sthird quarter to $11.99 today. The company also reported a net income loss of $627.5 million, or $0.68 per share. However, because Annaly's GAAP net income does not always give a clear picture of earnings from operations, the company uses a non-GAAP measure: core earnings. This figure declined from $0.41 per share in the previous quarter to $0.21 in Q3 2015.

Annaly's third-quarterheadline numbers look pretty bleak. But the good news is that things were better than those headline numbers suggest. Annaly also continued to diversify into credit investments. This shift will be important to watch, and could be a potential game-changer in terms of the company's long-term capabilities.

Why the net income loss? The company's substantial decline in net income was "primarily the result of unfavorable market value changes on interest rate swaps," it said in its report. In total, Annaly took $823 million in unrealized losses during the quarter.

Interest rate swaps are agreements between two parties to exchange future interest rate payments. In Annaly's case, this involves it trading its floating interest rates for fixed-rates, effectively locking in its borrowing costs and hedging its exposure to rising interest rates. But interest rates fell 12% during the third quarter, and Annaly's swap agreements therefore lost market value.

However, net income doesn't tell the whole story. Annaly's core business is investing in fixed-income real estate-backed securities, and unrealized gains and losses on those investments are not included within net income. To see those changes reflected, you need to look at its comprehensive income figure. During the third quarter, Annaly had $610 million in gains on their securities. This boosts Annaly's comprehensive income to a loss of just $9 million. That's still not ideal, but it is better than the net income loss of over $600 million, and is a more accurate depiction of what happened.

What about the dividend? Comprehensive income provides the big picture. But because it includes unrealized gains and losses, it is a poor measure of whether Annaly can cover its dividend. To find that number, Annaly slices out everything that is not directly related to its core operations and comes up with core earnings.

During the third quarter, Annaly reported core earnings of $0.21 per share. That was well below Annaly's quarterly dividend of $0.30, and when Annaly's core earnings fall, its dividend typically follows.

On a positive note, core earnings for the first nine months of 2015 totaled $0.87 per share -- just a shade under the $0.90 in dividends Annaly has paid out this year. If earnings continue on this pace, the dividend should be fine. However, if core earnings continue the downward trend they have been on from 2011 to today, a dividend cut is a real possibility.

A new direction The problem is that Annaly does not have a lot of good options for boosting its profits. For instance, Annaly could grow earnings by borrowing more heavily against its equity to buy additional securities; more securities means more cash flow. But the threat of rising interest rates is looming, and higher rates could devastate Annaly's book value. This is because when interest rates rise, it lowers the market value of thesecurities Annaly holds.

Desperate times call for desperate measures. Annaly has in the past made a living out of investing solely in agency mortgage-backed securities issued by Fannie Mae and Freddie Mac, but the company has been shifting directions.

As of the third quarter, 18% of Annaly's $12.3 billion in equity was invested in credit-sensitive investments. That was a 26% increase over the previous quarter. Unlike the securities it has traditionally held, these assets carry the risk of default. That makes them riskier, but they are also higher yielding and less affected by prevailing interest rates. Among these investments are more-exotic residential mortgages and -- the bigger piece -- commercial mortgage loans. This segment has already made splash by providing a $592 million loan to Blackstoneand Fairstead Capital for acquiring apartments in New York City this past September.

The Blackstone deal is a good example of how commercial lending allows Annaly to take full advantage of its scale, access to capital, reputation, and existing relationships. The current environment has been tough on Annaly, but the company's commercial real estate group is a bright spot, creating an entirely new dynamic. I expect it to become an increasingly important complement to Annaly's traditional business.

The article Annaly Capital Managment Inc.'s Third Quarter Earnings: What You Need to Know originally appeared on Fool.com.

Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.